The "cake test" checklist when considering companies as investments

The "cake test"

Some of you may be familiar with the technique of sticking a toothpick into a cake to determine whether it's done. Try it a few times in different parts of the cake to verify your conclusion.

Especially for time-constrained investors, the "cake test" approach makes sense to review financial statements. Poke here, poke there, read some of the notes, get a favour for financial reporting quality. If you're Warren Buffett, ready to commit $2 billion to a company, you may want to take a closer look. But for most of us, the following will help.

A checklist

The following are a few places to test when considering companies as investments.

Earnings consistent with cash flow
These two things won't be equal but should march side by side. If earnings consistently grow faster than cash flow, that's a bad sign.

Growing current assets other than cash
Watch for increasing inventories or account receivable, particularly in proportion to sales.

Straight-line depreciation and amortizatizion, long time periods
Asset recovery may be delayed through deferring depreciation and amortizaton in order to boost earnings. Understand what practice the company uses, and whether it’s consistent with others in the industry – and common sense.

Understand asset impairments
Note which assets are “impaired” or on the block for possible write-downs, and understand why.

LIFO versus FIFO
LIFO is a more conservative approach to measuring cost of goods sold and inventory levels, as most of the recent (and more expensive) stock is assumed to be consumed first. Note that this may not be true in every industry.

Reserves against bad debts change dramatically
Watch for bad debt and other reserves as a sign of deterioration in current asset quality.

Accounting policy change
Note 1 should be simple and straightforward. Look at revenue and cost recognition. Complex, unexplained changes may spell trouble.

10-K report is longer than 100 pages
Something complex is going on. Opportunity knocks for accounting fiction and other things that are hard to understand.

Persistent, poorly explained write-offs
If the write-offs are large or repetitive, try to understand why.

Big gap between pro forma and GAAP
Understand why and what the company is trying to tell you by reporting both.

Understand where the revenues come from – if the company tells you
What are the major revenue “segments”? Does the company have a few big customers? Who are they? Are their business fundamentals sound? Does the company have channel partners? What are their selling arrangements with those partners? Do they provide financing? What are the other incentives? Are services broken out separately?

Stay with those who explain best.
Better corporate financial statements explain changes in their business and changes in their accounting policies. It’s worth reading their explanations carefully. Remember, companies that explain things better are probably better investments.